Lecture 11. Money and Banking. Money. 1. Why do we have money? There are
three basic functions that money serves a) Medium of exchange. • allows for the ...
Lecture 11
Money and Banking
Money 1. Why do we have money? There are three basic functions that money serves a) Medium of exchange • allows for the specialization of workers. They receive money wages to buy goods needed rather than produce their own goods. • avoids the problem of the double coincidence of wants. In a society with barter you must find someone who has what you desire and wants what you have produced. b) Accounting Unit: allows valuation and pricing in a common unit c) store of value: in barter, need to store goods which could perish or lose value. e.g. light blue leisure suit with polyester floral print shirt. With money one can store value over time. Advantages of money highly liquid as compared to stocks and bonds. Disadvantages of money Loses value during inflationary periods or episodes. Different Types of Money a) Commodity Money has value as a commodity such as rice, cattle, seashells, copper, stones, cigarettes as used in the POW camps of WWII. problems • when valuable resources are used as money, those resources cannot be used for consumption. Copper used to make pennies cannot be used to make electrical wire. • There exists an incentive to debase the currency. Rulers would reduce the amount of the precious metal in a coin. People would tend to circulate the altered coins and save the coins which still had the greater amount of the precious metal. This is known as Gresham’s law: bad money drives out good. • The supply of money is determined by supply of the commodity. The money supply could fluctuate substantially. The discovery of new gold would mean that the supply of money would increase and the price level would rise. b) Fiat Money (has nothing to do with an Italian sports car) very little value as a commodity money because the public accepts it as money (not necessarily because the government declares it as money) Peopel accept it because they believe that everyone else will accept it. This is very different from a “fully backed” currency that is a currency that is backed by some commodity like gold or silver. For example in the early part of this century the US still had silver dollar notes. If one wanted one could take the note to the treasury and demand the silver which was held since the inception of the note as a form of its backing. 1
advantages of fiat money • uses relatively little of society’s resources • no incentive to debase this type of currency • supply not tied to commodity. Therefore it potentially has less susceptibility to lead to fluctuation in the money supply. It can grow with the economy. • problem • government controls money supply and it may cause inflation by printing too much money Bank Money: checks backed by a bank account. in the US we have Fiat and Bank Money Money Supply Definitions Most liquid M1 = currency held by the public (not including the banks) 25% + demand deposits (non-interest checking accounts) >74% + other checkable deposits (interest bearing checking) +traveller’s checks 1% Less liquid M2 = M1 + savings deposits + money market mutual fund share, deposits + small time deposits ($100,000) We usually refer to M1 as the money supply. Credit cards are not money-they are short-term loans which must be paid off using money. Banking System Private institutions: banks, S and L’s, credit unions, etc. (will refer to these as banks) Central Bank (Federal Reserve): Board + Regional Banks • oversees banking system • independent of congressional and the executive branches. Bank Balance Sheet Assets vault cash reserves at the Federal Reserve loans securities and other total assets =
2
Liabilities deposits borrowing net worth total liabilites
Bank Balance Sheet Assets vault cash reserves at the Federal Reserve loans securities and other total assets
Liabilities deposits borrowing net worth total liabilites
=
Bank assets consist of IOU’s: loans to persons and firms, government bonds, deposits with other banks, liabilities consist of deposits customers have made - demand deposits, savings deposits, and time deposits bank reserves: vault cash plus reserves at the Fed (which earn no interest) banks do not have enough reserves to cover all deposits (hence that is why our system is referred to as a “fractional reserve system”). Usually banks only hold enough to meet required reserves. banks use excess reserves to make loans which earn interst. When a banks net worth is >0 then it is solvent; when net worth is
